France's Downgrade Threatens the Eurozone's AAA

01/16/2012 11:03 am ET
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Updated
Mar 17, 2012

Georges Ugeux
Chairman and CEO, Galileo Global Advisors and Adjunct professor at Columbia Law School

Among the nine European sovereign down ratings announced by Standard & Poor's last Friday, France's lost of its precious AAA is the most significant. While it did not come unannounced (S&P had recently warned the governments that it was reviewing the Eurozone ratings) and was widely anticipated, it is a significant development that will impact both the country and the Eurozone.

While President Sarkozy was making France's AAA rating a « national treasure », his government was increasing its budget deficit beyond other AA borrowers (6-7% in 2011) and its indebtedness. Over the five year of his flamboyant presidency, the country's debt increased from 1,100 to 1,700 billion euros, i.e. 55%. In GDP terms it went from 65% to 85%.
This irresponsible behavior has not been unnoticed. While Germany's 10-year bonds decreased from 3 to 1.7% (a notch lower that the US at 1.8%), France's oscillated between 3 and 4.3% in 2011. On Monday January 16, its bonds did not lose value, confirming that markets had already priced a non-AAA France for a while
France, for all practical purposes, was not a AAA in the eyes of investors and a policy to make a rating like a fetish was ill-conceived. The boomerang effect is both politically and financially strong.

It would not matter so much is France was the only affected country. But the country, that was holding all kind of presidencies from the G 20, the G 8 or the European union, knew perfectly well that the bailout mechanism for the European over indebted countries was dependent on its AAA.
The European Fund for Financial Stability (EFSF)was set up in May 2011 to provide long-term low-interest financing to Greece. In order to grant the EFSF bonds a AAA rating the 16 Member States of the Eurozone guaranteed the bonds. Until Friday, 55% of the guarantees were rated AAA. With a 20% share, France has now tilted the balance of AAA guarantors that only amounts to 35%, and four countries out of 16: Germany (27%), the Netherlands, Finland and Luxembourg. The EFSF bonds will no longer carry a AAA rating. Fortunately the EFSF loans amount to less than 12.4 billion euros, but their yield is going to grow making EFSF bondholders the victims of this change. It never reached its original limit of 440 billion euros, let alone its utopic limit of 1,000 billion euros announced in October 2011.

Will this downgrading reach the whole Union (27 countries)? The European Union has put in place a European Financial Stability Mechanism (EFSM) that issued 48.5 billion euros to rescue Portugal and Ireland. Its guarantor is the European budget, and indirectly the Member States. They are the only true "Eurobonds" issued by the EU. Its maximum authorization amounts to 60 billion euros.
The most important European borrower is the European Investment Bank. Directly owned and therefore backed by the 26 Member States, the EIB is the most important multinational borrower in the world: at mid 2011 it had the equivalent of 310 billion euros issued in many currencies, mostly the Euro and the US Dollar. Its balance sheet is strong with 223 billion euros capital, but only 10% is paid -in. Its loans are generally guaranteed by the Member States or by banks with ratings of A or more.

By not applying to itself the discipline it has been keen to impose to other countries, France is knowingly opening The European creditworthiness's Pandora box. Europe's AAA rating is in danger, and with it its ability to fund its unavoidable bailout plans.